Judge Rakoff Whacks SEC Yet Again, This Time Over Citi CDO Settlement

Judge Jed Rakoff’s latest ruing, nixing a $285 million settlement between the SEC and Citigroup over a billion dollar fund that came a cropper, has broader implications than simply embarrassing the securities regulator (which given the fallen standing of the agency, and low standards in Washington generally, is harder to do than it ought to be). Rakoff has effectively said judges have no business sanctioning settlements in which the accused party admits to nothing.

What has Rakoff’s dander up is that the allegations made by the SEC in its lawsuit were that Citigroup stuffed the fund full of crappy CDO tranches and went short against them, and got investors to buy it by telling them the assets were selected by an independent party. Citi was a typically inefficient looter, earning about $160 million while investors lost $700 million (note that Rakoff had to pry that information out of the parties). Citi is admitting only to negligence when the violations the SEC described its filing and in a related case amount to fraud, or in securities speak, scienter.

Rakoff’s ruling calls the entire process a sham:

Here, the S.E.C.’s long-standing policy – hallowed by history, but not by reason – of allowing defendants to enter into Consent Judgments without admitting or denying the underlying allegations, deprives the Court of even the most minimal assurance that the substantial injunctive relief it is being asked to impose has any basis in fact.

Rakoff’s job is to determine whether the ruling is “whether the proposed Consent Judgment … is fair, reasonable, adequate, and in the public interest.” Since Citi admits to essentially nothing, he has no factual foundation for determining the adequacy of the settlement. He also notes that this deal clearly helps the big bank, since it’s a screaming deal if Citi did the bad things the SEC claimed it did in its initial lawsuit, and is a mere cost of doing business if it didn’t. It isn’t obvious to him what the SEC gets, beyond a headline. And he notes it leaves investors worse off, since the SEC has not said whether or not it will give any of its fines to them, plus the settlement means they cannot pursue private securities law claims based on negligence, so they are actually worse off.

The settlement includes injunctive relief, which in this case is to permanently restrain and enjoin Citi from violating certain provisions of securities regulations, and for three years to implement certain internal programs to prevent staff from undertaking this fraud. Rakoff pooh poohed that, noting that the SEC showed Citi to be a recidivist. The New York Times confirmed Rakoff’s dim view:

A recent analysis by The New York Times of the agency’s fraud settlements with Wall Street firms found 51 instances, involving 19 companies, in which the agency claimed that a company had broken fraud laws that they previously had agreed never to breach.

Dealbreaker (hat tip reader Alexis) raises a related issue: why should the SEC file suits when it can just use administrative actions and collect fines and slap wrists that way? Author Matt Levine points out that they get better headlines, and I assume better settlements (more potential for embarrassment makes it even more important for a suit to go away). The New York Times concurred:

Securities law experts said that the ruling presents the agency with a tough dilemma. In future cases, it will have to consider the risk that another judge may be reluctant to approve a settlement given the Rakoff ruling.

But it isn’t as if the SEC can avoid the court system either. As Levine notes:

Bringing lawsuits in the Southern District of New York is a good way to get the SEC’s failings noticed. Bringing SEC administrative actions, announcing big fines with upbeat press releases, and not having them subject to any review, is a good way to sweep them under the rug. The more scrutiny that the SEC gets when it goes to court, the more tempted it will be to handle cases like this on its own.